RISK MANAGEMENT TOOLS
WHAT IS RISK MANAGEMENT ???
Risk management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. Because the term risk is ambiguous and has different meanings, risk managers typically use the term loss exposure to identify potential losses.
Risk management is a scientific approach to the problem of risk that has as its objective the reduction and elimination of risks facing the business firm. Risk management evolved from the field of corporate insurance buying and is now recognized as a distinct and important function for all businesses and organizations.
In the broad sense of the term, risk management is the process of protecting one’s person and assets. In the narrower sense, it is a managerial function of business that uses a scientific approach to dealing with risks. As such, it is based on a specific philosophy and follows a well-defined sequence of steps.
RISK MANAGEMENT DEFINITION
“Risk management is a scientific approach to dealing with risks by anticipating possible losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.”
Risk management is usually the responsibility of the top management and performed by risk managers. These managers must consider economic, social, political legal factors while taking decisions as the decision taken by these managers have b impact on not only their business but also on the entire economy. In case of and controversy, decision-makers must be able to justify the decisions. They are accountable to the whole nation for their decisions. Stakeholders, shareholders, consumers, government, creditors etc. are interested in the details of the risk analysis, as well as the overall results. It is the duty of top management to satisfy the stakeholders with their decision even if there is some additional cost or risk involved in it.
RISK MANAGEMENT TOOLS
The definition of risk management states that it deals with risk by designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur. This indicates the two broad techniques that are used in risk management for dealing with risks. In the terminology of modern risk management, the techniques for dealing with risk are grouped into two broad approaches: risk control and risk financing.
Risk control focuses on minimizing the risk of loss to which the firm is exposed and includes the techniques of avoidance and reduction. Risk financing concentrates on arranging the availability of funds to meet losses arising from the risks that remain after the application of risk control techniques and includes the tools of retention and transfer.
Various risk management tools are as follows:
RISK MANAGEMENT TOOLS: 1. RISK CONTROL
Broadly defined, risk management tools consist of those tools or techniques that are designed to minimize, at the least possible costs, those risks to which the organization is exposed. Risk management tools include risk avoidance and the various approaches at reducing risk through loss prevention and control efforts.
Risk Avoidance as Risk Management Tools
Technically, avoidance takes place when decisions are made that prevent a risk from even coming into existence. Risks are avoided when the organization refuses to accept the risk, even for an instant.
The classic example of risk avoidance by a business firm is a decision not to manufacture a particularly dangerous product because of the inherent risk. Given the potential for liability claims that may result if a consumer is injured by a product, some firms judge that the risk is not worth the potential gain.
Risk avoidance as one of the risk management tools should be used in those instances in which the exposure has catastrophic potential and the risk cannot be reduced or transferred. Generally, these conditions will exist in the case of risks for which both the frequency and the severity are high and neither can be reduced. Although avoidance is the only alternative for dealing with some risks, it is a negative rather than a positive approach. Personal advancement of the individual and progress in the economy both require risk taking. If avoidance is used extensively, the firm may not be able to achieve its primary objectives.
A manufacturer cannot avoid the risk of product liability by avoiding the risk and still stay in business. For this reason, avoidance is, in a sense, the last resort in dealing with risk. It is used when there is no other alternative.
Risk Reduction as Risk Management Tools
Risk reduction consists of all techniques that are designed to reduce the likelihood of loss, or the potential severity of those losses that do occur. It is common to distinguish between those efforts aimed at preventing losses from occurring and those aimed at minimizing the severity of loss if it should occur, referring to them respectively as loss prevention and loss control.
As the designation implies, the emphasis of loss prevention is on preventing the occurrence of loss; that is, on controlling the frequency. Prohibition against smoking in areas where flammables are present is a loss prevention measure. Similarly, measures to decrease the number of employee injuries by installing protective devices around machinery are aimed at reducing the frequency of loss.
Other risk reduction techniques focus on lessening the severity of those losses that actually do occur, such as the installation of sprinkler systems. These are loss control measures. Other methods of controlling severity include segregation or dispersion of assets and salvage efforts. Dispersion of assets will not reduce the number of fires or explosions that may occur, but it can limit the potential severity of the losses that do occur. Salvage operations after a loss has occurred can minimize the resulting costs of the loss.
A final way of classifying risk reduction measures is by the timing of their application, which may be prior to the loss event, at the time of the event, or after the loss event. Safety inspections and drivers’ training classes illustrate measures that are designed to prevent the occurrence before losses occur. Seat belts and air bags are designed to minimize the amount of damage at the time an accident occurs. Post-event loss prevention measures related to auto accidents include negotiating with injured persons for an out-of-court settlement or a stern defence in litigation.
RISK MANAGEMENT TOOLS: 2. Risk Financing
Risk financing, in contrast with risk control, consists of those techniques that focus on arrangements designed to guarantee the availability of funds to meet those losses that do occur. Fundamentally, risk financing takes the form of retention or transfer. All risks that cannot be avoided or reduced must, by definition, be transferred or retained. Frequently, transfer and retention are used in combination for a particular risk, with a portion of the risk retained and a part transferred.
Risk Retention as Risk management tools
Risk retention is perhaps the most common method of dealing with risk. Individuals, like organizations, face an almost unlimited number of risks; in most cases, nothing is done about them. Risk retention may be conscious or unconscious (i.e., intentional or unintentional). Because risk retention is the “residual” or “default” risk management technique, any exposures that are not avoided, reduced, or transferred are retained. This means that when nothing is done about a particular exposure, the risk is retained.
Unintentional (unconscious) retention occurs when a risk is not recognized. The individual or organization unwittingly and unintentionally retains the risk of loss arising out of the exposure. Unintentional retention can also occur in those instances in which the risk has been recognized but when the measures designed to deal with it are improperly implemented.
If, for example, the risk manager recognizes the exposure to loss in connection with a particular exposure and intends to transfer that exposure through insurance but then acquires an insurance policy that does not fully cover the loss, the risk is retained. Unintentional risk retention is always undesirable. Because the risk is not perceived, the risk manager is never afforded the opportunity to make the decision concerning what should be done about it on a rational basis. Also, when the unintentional retention occurs as a result of improper implementation of the technique that was designed to deal with the exposure, the resulting retention is contrary to the intent of the risk manager.
Risk retention may be voluntary or involuntary. Voluntary retention results from a decision to retain risk rather than to avoid or transfer it. Involuntary retention occurs when it is not possible to avoid, reduce, or transfer the exposure to an insurance company. Uninsurable exposures are an example of involuntary retention.
The form that risk retention may assume varies widely. Retention may be accompanied by specific budgetary allocations to meet uninsured losses and may involve the accumulation of a fund to meet deviations from expected losses.
On the other hand, retention may be less formal, without any form of specific funding. A larger firm may use a loss-sensitive rating program (in which the premium varies directly with losses), various forms of self-insured retention plans, or even a captive insurer. The small organization uses deductibles, noninsurance, and various other forms of retention techniques. The specific programs may differ, but the approach is the same.
Risk Transfer as Risk management tools
Transfer may be accomplished in a variety of ways. The purchase of insurance contracts is, of course, a primary approach to risk transfer. In consideration of a specific payment (the premium) by one party, the second party contracts to indemnify the first party up to a certain limit for the specified loss that may or may not occur.
Another example of risk transfer is the process of hedging, in which an individual guards against the risk of price changes in one asset by buying or selling another asset whose price changes in an offsetting direction. For example, futures markets have been created to allow farmers to protect themselves against changes in the price of their crop between planting and harvesting. A farmer sells a futures contract, which is actually a promise to deliver at a fixed price in the future. If the value of the farmer’s crop declines, the value of the farmer’s future position goes up to offset the loss.
Risk transfer may also take the form of contractual arrangements such as hold-harmless agreements, in which one individual assumes another’s possibility of loss. For example, a tenant may agree under the terms of a lease to pay any judgments against the landlord that arise out of the use of the premises. Risk transfer may also involve subcontracting certain activities, or it may take the form of surety bonds.